What Is an Exchange Rate? the Rate at Which One Currency Can Be Exchanged for Another;

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What is an exchange rate? The rate at which one currency can be exchanged for another; that is, the price of one country’s currency expressed in another country’s currency.

Exchange rates change constantly. Since most currencies are freely traded around the world on electronic change, we see constant – literally 24-7 – changes in exchange rates.

While there’s a lot of debate amongst economists (surprise, surprise) about what causes exchange rates to change, there is a consensus that the following 6 factors are important:

•Inflation rates: generally, countries with lower inflation rates have higher-valued currencies

•Interest rates: higher interest rates often mean that investors get a better return in one country than another, and so sometimes push the value of a country’s currency up compared to low interest countries

•Current account deficits: a current account deficit means that a country is spending more on foreign trade (via imports) than it is earning (via exports), and so it will need to borrow from other countries to finance its deficit – and generally this means the value of its currency will decline

•Level of public debt: if a country is running very large budget deficits, and borrowing to cover this cost, you will often see high inflation, which in turn will often mean a lower currency valuation.

•Terms of trade: the terms of trade means the difference in the price of exports to the price of imports – a positive terms of trade means the prices a country gets for its exports is higher than the price it pays for its imports. Generally, the stronger the terms of trade, the stronger the currency, which has definitely been affecting the Aussie dollar in recent years

Stability and economic growth: finally, the level of political stability, and whether an economy is growing at all, matters to investors. Stable, growing countries are lower risk, and therefore tend to have stronger currency valuations.

One of the big problems faced by Europe, of course, is that some countries in Europe have these problems (eg Greece and Italy have huge public debts), while others like Germany don’t – but all of them share the same currency! That means that despite economic fundamentals meaning Greece should have a lower-valued currency, it is “stuck” with a higher valued Euro. European exchange rate changes are often harder to understand or predict as a result.

It’s interesting to note that Australia hasn’t always had a floating exchange rate. Up until 1983, in fact, the value of the Australian dollar was fixed against other currencies. Before 1971, the Australian dollar was regularly fixed as a percentage of the UK pound. After that, the US dollar was used, and on several occasions, a “basket of currencies” called a Trade Weighted Index was used. The Reserve Bank of Australia believes that the floating exchange rate in place since 1983 has been a big contributor to our economic success since then, as it “absorbs” shocks to the economy, such as when prices or demand for our commodity exports like coal or iron ore move suddenly.

Fluctuations in exchange rates are due to the buying and selling activities of currency investors.

Everyone is aware that foreign exchange trading rates fluctuate up and down but are they aware as to the reason they do. In a nutshell the reason they fluctuate is simply the change in supply and demand. If a currency is in demand and more than the available supply the price is driven up and it becomes more valuable. If on the other hand the supply is greater than the demand the price is driven down and the currency becomes less valuable. Let’s look at the reasons why supply and demand changes.

Fluctuations in exchange rates:

When the demand for a currency is less than the supply it does not mean that nobody wants money any more. It simply means that investors and businesses want their wealth in another asset (another currency) or another form of asset (commodities or stocks). The increase in a currency is either due to the economic outlook in a particular country or the central banks policy on interest rates.

Reading a Quote

When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen. The forex quote includes the currency abbreviations for the currencies in question.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, either directly or indirectly. A direct currencyquote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit.

For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which means with C$1, you can purchase US$0.85. The indirect quote for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that USD$1 will purchase C$1.18.

In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. In these cases, it is called a direct quote. This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen.

However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro, which is relatively new, is quoted the same way as well. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect quote. This is why the EUR/USD quote is given as 1.25, for example, because it means that one euro is the equivalent of 1.25 U.S. dollars.

Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.